When we first started helping investors build globally diversified portfolios, we quickly realized that many people focus entirely on the underlying investments while completely overlooking currency risk. Yet currency fluctuations can sometimes add or subtract several percentage points from your annual returns—often more than the management fees you pay.
Understanding currency risk is crucial for anyone holding international investments, whether through individual foreign stocks, international mutual funds, or global ETFs.
What Is Currency Risk?
Currency risk, also called foreign exchange risk, is the potential for currency fluctuations to impact your investment returns when you hold assets denominated in foreign currencies.
Here’s a simple example: Let’s say you invest $10,000 in a European stock fund when the euro trades at $1.20. Your investment buys €8,333 worth of European stocks. Over the year, the European stocks gain 8% in euro terms, bringing your investment to €9,000.
However, if the euro weakens to $1.10 during this period, your investment is now worth $9,900 (€9,000 × $1.10), giving you a loss of 1% despite the 8% gain in the underlying stocks. The 9-point currency move completely overwhelmed the stock performance.
Conversely, if the euro had strengthened to $1.30, your €9,000 would be worth $11,700, giving you a 17% return—the 8% stock gain plus a 9% currency boost.
How Currency Risk Impacts Different Asset Classes
International Stocks
Individual foreign stocks carry direct currency exposure. When you buy Toyota shares on the Tokyo Stock Exchange, you’re exposed to both Toyota’s business performance and the USD/JPY exchange rate.
International Funds and ETFs
Most international funds carry currency risk unless specifically hedged. When you invest in a European stock fund, you’re effectively making two bets: that European stocks will outperform and that the euro will maintain or strengthen its value against the dollar.
International Bonds
Currency risk is often more significant for international bonds than stocks because bond returns are typically lower and more stable, making currency moves a larger component of total returns.
Emerging Market Investments
Emerging market currencies tend to be more volatile than developed market currencies, potentially creating larger currency impacts on your returns.
Geographic Diversification vs Currency Risk
One of the key tensions in international investing is balancing the benefits of geographic diversification with the added complexity of currency risk.
We’ve observed that while international diversification can reduce overall portfolio risk, currency volatility sometimes increases short-term portfolio volatility. The key is understanding whether the diversification benefits outweigh the currency risks for your specific situation.
International investing provides access to different economic cycles, regulatory environments, and growth opportunities that aren’t available in domestic markets alone. However, adding currency risk means your returns become dependent on factors beyond the performance of the underlying businesses or economies.
Hedged vs Unhedged International Funds
Financial markets offer two main approaches to handling currency risk in international investing:
Unhedged Funds
These funds provide full exposure to both the underlying investments and currency movements. When you invest in an unhedged international fund, you experience the complete return profile of foreign markets, including currency impacts.
Advantages of Unhedged Funds:
- Lower management fees (no hedging costs)
- Full upside potential from favorable currency moves
- True international diversification including currencies
- Simpler structure and operation
Disadvantages of Unhedged Funds:
- Added volatility from currency fluctuations
- Potential for strong underlying performance to be offset by weak currencies
- More complex return patterns to analyze and understand
Hedged Funds
These funds use financial instruments like forward contracts and currency swaps to neutralize most currency exposure, allowing you to focus on the underlying investment performance.
Advantages of Hedged Funds:
- Reduced volatility from currency movements
- Returns more closely track underlying market performance
- Easier to analyze true investment performance
- Can be combined with separate currency exposure if desired
Disadvantages of Hedged Funds:
- Higher management fees (typically 0.1-0.3% more)
- Miss potential gains from favorable currency moves
- Hedging isn’t perfect—some currency exposure usually remains
- Less true international diversification
When Currency Hedging Makes Sense
The decision between hedged and unhedged international exposure isn’t one-size-fits-all. Consider hedging when:
You Want to Isolate Investment Performance
If you’re investing internationally specifically to access different markets and economies without taking currency bets, hedged funds provide cleaner exposure to your intended risk factors.
Your Portfolio Is More Conservative
Currency volatility can significantly increase overall portfolio volatility. Conservative investors who want international exposure but not additional volatility often prefer hedged funds.
You’re in or Near Retirement
Sequence of returns risk makes volatility particularly dangerous in early retirement. Hedging can reduce one source of portfolio volatility during this critical period.
You Have Strong Dollar Views
If you believe the dollar will strengthen significantly, hedging your international exposure removes a potential headwind to your returns.
When to Accept Currency Risk
Unhedged international investing makes sense when:
You Want Complete Diversification
Currencies provide another diversification dimension that can reduce portfolio risk over long periods, even if they increase short-term volatility.
You Have Long Time Horizons
Over 10+ year periods, currency movements tend to be less directional, and the diversification benefits often outweigh the volatility costs.
You Want Lower Costs
The fee difference between hedged and unhedged funds compounds over time. For long-term investors, saving 0.2-0.3% annually in fees can significantly impact wealth accumulation.
You Believe in Purchasing Power Parity
Economic theory suggests currencies should eventually reflect relative purchasing power between countries. If you believe this works over long periods, currency timing becomes less important.
Measuring Currency Impact on Your Portfolio
Understanding currency risk requires looking beyond simple return numbers to see how currency movements affected your international investments.
Currency Contribution Analysis
Many portfolio analysis tools can break down international investment returns into:
- Local market performance (what the investments did in their home currencies)
- Currency impact (how exchange rates affected your returns)
This breakdown helps you understand whether strong or weak international performance came from the underlying investments or currency movements.
Tracking Currency Exposure
Calculate your total currency exposure by asset:
- Unhedged international stock funds: Full currency exposure
- Hedged international funds: Minimal currency exposure
- International bond funds: Often significant currency exposure
- Domestic multinationals: Indirect currency exposure through business operations
Understanding this exposure helps you make informed decisions about whether to add currency hedging to your portfolio.
Building Currency-Aware Portfolios
Rather than choosing entirely hedged or unhedged approaches, many sophisticated investors use combinations:
Core-Satellite Approach
Use hedged international funds for your core international allocation (reducing volatility) and smaller unhedged positions for satellite allocations (capturing currency diversification benefits).
Regional Hedging Decisions
You might hedge developed market exposure (where currencies are less volatile) while leaving emerging market exposure unhedged (where currency moves might provide valuable diversification).
Time-Based Hedging
Some investors hedge more of their international exposure as they approach major financial goals, then reduce hedging afterward to recapture diversification benefits.
Currency Risk and Portfolio Rebalancing
Currency movements can significantly affect your portfolio allocation percentages. A strong dollar makes your domestic investments worth more relative to international holdings, potentially creating allocation drift that requires more frequent rebalancing.
We’ve found that portfolios with significant unhedged international exposure often need more attention to maintain target allocations, especially during periods of major currency moves.
Advanced Currency Considerations
Correlation Changes
Currency correlations with other assets change over time and market conditions. During financial crises, currencies often move together, reducing their diversification benefits precisely when you need them most.
Inflation Protection
Some currencies provide better inflation protection than others. During periods of high domestic inflation, foreign currency exposure might help preserve purchasing power.
Interest Rate Differential Impact
Countries with higher interest rates often have stronger currencies over time, but this relationship isn’t guaranteed and can reverse during economic stress.
Making Practical Currency Decisions
For most investors, currency decisions come down to a few practical considerations:
- Risk tolerance: Higher risk tolerance generally supports accepting currency risk for diversification benefits
- Investment timeline: Longer timelines favor accepting currency risk
- Cost sensitivity: Currency hedging costs money that compounds over time
- Complexity preference: Hedged funds are simpler to analyze and understand
Rather than trying to time currency movements or make complex predictions about exchange rates, focus on whether currency risk fits your overall portfolio risk management strategy and investment objectives.
The Role of Home Bias
Many investors have significant “home bias”—overweighting domestic investments relative to global market capitalization. While this reduces currency risk, it might also reduce diversification benefits and growth opportunities available in international markets.
Understanding currency risk can help you make more informed decisions about how much international exposure fits your situation, rather than avoiding international investing entirely due to unfamiliarity with currency effects.
Currency risk in international investing requires balancing the diversification benefits of global exposure against the added complexity and volatility of currency movements. The right approach depends on your risk tolerance, investment timeline, and preference for simplicity versus complete diversification.
Rather than avoiding international investing due to currency concerns, understanding these risks helps you make informed choices about hedged versus unhedged exposure that align with your overall investment strategy.
Some of these currency relationships can be complex to track and analyze, especially as exchange rates and correlations change over time. Tools like OnePortfolio can help by providing clear visibility into your currency exposures and how they’ve impacted your investment performance.
Want to understand how currency movements are affecting your international investments? Try OnePortfolio Free to analyze your currency exposure and its impact on your portfolio performance.
